IG Corporates: Be Selective

Attractive yields and a rally in credit spreads made 2023 a solid year for investment grade bond investors after two consecutive years of negative returns. With expectations that the Fed may achieve its goal of a “soft landing” and could cut rates in 2024, recent flows indicate that fixed income investors have begun to add back credit and duration risk into their portfolios. We believe being selective within the investment grade corporate bond market may provide a better outcome in 2024, just like it did in 2023 and prior years.

In particular, focusing on attractively valued bonds has historically provided significant outperformance. The market is not homogenous and there is significant dispersion of credit risk pricing within the corporate bond market. This offers the ability to build diversified portfolios with alpha potential, without taking excessive risk. Using Moody’s Analytics proprietary credit metrics allows us to assess the fair value of every bond in the U.S. corporate bond market and compare that value against market pricing. We define attractively valued bonds as those offering a significant excess spread above their fair value, meaning their market spread is overcompensating versus what it is needed based on the actual embedded risk.

Deviation from Fair Value Creates Opportunity – Investment Grade Bond Universe (As of 12/31/2023)

Source: Moody’s Analytics, ICE Data Services and VanEck, as of 12/31/2023. Past performance is no guarantee of future results.

Focusing on high excess spread does not simply mean selecting bonds with the highest yield. Fair value considers factors including the probability of default, expected recovery rate, sector-specific considerations, and the level of systematic risk in the market. It also considers bond-specific factors, including the bond’s price, maturity, and seniority. Further, a bond’s credit rating is not enough to determine whether a bond may provide attractive value. Ratings are not forward-looking or responsive to market-based information, as they tend to lag the market and current economic developments, so they don’t provide an adequate basis to base all security selection decisions on.

By focusing on bonds with the most attractive valuations relative to their risk has provided attractive total returns driven by both greater price and income returns versus the broad market.

Attractive Price and Income Returns

Source: ICE Data Services, as of 12/31/2023. The MarketVector IG Index represented by the MVIS Moody’s Analytics US Investment Grade Corporate Bond Index. The US IG Benchmark is represented by the ICE BofA US Corporate Bond Index. The MarketVector BBB Index represented by the MVIS Moody’s Analytics US BBB Corporate Bond Index. The US BBB Benchmark is represented by the ICE BofA BBB US Corporate Bond Index.

Instead of traditional measures like credit ratings, we rely on the industry-leading credit model developed by Moody’s Analytics to identify attractively valued bonds that may provide upside potential. We illustrate below how a key output of the model, the fair value spread, is used to identify relative value opportunities in the marketplace as they arise. In the below example, four bonds with several common traits are highlighted: all are rated BBB-, all have approximately five years to maturity, and all have at least $1 billion of par amount outstanding. From a rating, duration and liquidity perspective, these bonds are all very similar. However, there is clear differentiation from a risk perspective when viewed in the context of their excess spreads (the difference between fair value and market price).

Differences in sectors account for some of the difference, but the different fair values are also driven by the underlying credit risk of the bonds. In this example, the Charter Communications bond issue, the Enbridge and the PG&E are offering attractive value, meaning that these bonds are undervalued by the market, and investors are earning more compensation for the lower level of risk being taken. Over time, if the market recognizes this mispricing and market spreads begin to tighten towards fair value spreads, bond prices will move upwards, all else equal, providing additional upside to investors.

Value Not Drive Only by Rating, Size or Maturity – Selected BBB3, >$1 billion Bonds 5 Year Bonds (as of 12/31/2023)

Source: Moody’s Analytics, ICE Data Services and VanEck. This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.

On the other hand, bonds such as the one issued by Boeing are overpriced. The market price is not compensating investors for the risk being taken, based on the model’s assessment of risk and value. Analyzing bonds through the lens of fair value allows investors to buy undervalued bonds and avoid overpriced bonds, which have demonstrated a better risk/reward profile than the broad markets. As we look ahead, we believe yield curve normalization and quantitative tightening may drive continued volatility, resulting in increased relative value opportunities that a value-oriented strategy can benefit from.

Risk/Reward (11/13/2020 – 12/31/2023)

Source: Morningstar. The MarketVector IG Index is represented by the MVIS Moody’s Analytics US Investment Grade Corporate Bond Index. The US IG Benchmark is represented by the ICE BofA US Corporate Bond Index. The MarketVector BBB Index represented by the MVIS Moody’s Analytics US BBB Corporate Bond Index. The US BBB Benchmark is represented by the ICE BofA BBB US Corporate Bond Index.

The VanEck Moody’s Analytics IG Corporate Bond ETF (MIG) seeks to track, as closely as possible, before fees and expenses, the price and yield performance of the MVIS^® Moody’s Analytics^® US Investment Grade Corporate Bond Index while the VanEck Moody’s Analytics BBB Corporate Bond ETF (MBBB) seeks to track, as closely as possible, before fees and expenses, the price and yield performance of the MVIS^® Moody’s Analytics^® US BBB Corporate Bond Index. These indices focus on the most attractively valued bonds based on their market spread relative to their fair value, based on metrics calculated by Moody’s Analytics. Both funds ranked within the Top-14% of the Morningstar US Fund Corporate Bond Category as of 12/31/2023.

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